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Asset Allocation Is Not Dead

Upon hearing the rumors of his demise, Mark Twain supposedly declared: "The reports of my death are greatly exaggerated." The financial media has been bombarding investors with claims of the demise of asset allocation and modern portfolio theory (MPT). These claims have as much validity as the claims about Twain's death.

Articles such as Felix Salmon's blog post on July 13 make that claim that asset allocation (diversification) failed miserably in 2008. In this article, Salmon claims that "In investing, nothing lasts forever. And the era of asset allocation is in its waning years."

Such articles claim that MPT and the concept of diversification are fundamentally flawed. While there's a fundamental flaw, it is not with MPT. It's with rumor mongers. Their flaw is that there was nothing really unique about what happened to the markets in 2008. It was just that the attackers don't know their financial history.

In 2008, the financial markets suffered greatly due to the appearance of a systemic risk (a global financial crisis caused by credit losses). The result was that the correlation of all risky assets headed towards one -- hence the claims about the death of asset allocation. By definition, systemic risks are risks that cannot be diversified away. All equities and risky fixed income assets will suffer whenever systemic risks appear. Examples are:

During each of these crises, all risky assets suffered. The way for you to guard against such risks is to include a sufficient allocation to safe fixed income assets (such as U.S. Treasury securities and high-rated municipal bonds) in your portfolio.

There's not much that's certain in the world of investing. However, I'm certain about one thing. Articles proclaiming the death of asset allocation and MPT will be remembered along with BusinessWeek's infamous "Death of Equities" forecast.

Further reading: Here are some MoneyWatch posts and articles for more information on diversification.

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